Closed Innovation paradigm

Traditionally new product development was an internal process in industrial companies. Most commonly, firms apply "closed" innovation strategy and limit their interactions with external environment (Lichtenthaler, 2011). This situation can be explained from the historical perspective. In the early 20-th century an enormous gap was observed between the university science and its application in business practice.

Despite the existent potential, the enterprises could not rely on the knowledge which was created in the universities. Furthermore, the universities did not have sufficient financial resources for the execution of large-scale experiments. (Chesbrough, 2003)

A number of reputable scientific leaders claimed that the scientists' talents should not be applied for solving commercial problems, which led to the separation of the science from the actual production and application. The activities of such scientists as Thomas Edison were perceived patronizingly as if they betrayed fair scientific ideals and agreed to compromise applying science into practice. (Chesbrough, 2003).

In addition, there was no possibility to rely on government support. The industry was a major source of financing for the research, which was initiated for further commercial use of the scientific results, and the main places for the research execution were laboratories of R&D departments. (Chesbrough, 2003).

Thus, taking into account these factors, perhaps the only solution was to make a discovery and commercially develop the scientific knowledge within a company. The creation of centralized research laboratories and independent product development were major factors facilitating the growth of industrial corporation. (Chesbrough, 2003)

The existing strict borders between the companies and scientific organizations determined an innovation system, within which the organizations explored and developed new products and services – the closed innovation paradigm. Figure 8 shows the process of managing R&D within this paradigm.

Figure 8. The current paradigm: The Closed Innovation model (Chesbrough et al., 2006b, p.3)

According to this paradigm, successful innovation requires control. Here, new projects are launched from science and technology base, then progress through the process, some of them are stopped and others are selected for the further actions.

(Chesbrough, 2006b) A company should generate its own ideas, then develop them, create a product based on them, then head for the market, after that distribute the product and get engaged in financing, service and support. This approach forces companies to rely only on themselves. (Chesbrough, 2003)

Robert Cooper (1990, p.44) argued in favor of the fact that America is in a product war and the key to winning this war is ―to drive new products from idea to market faster and with fewer mistakes‖ but noticed that only one project in four becomes a

winner. He offered Stage-Gate model as a solution where innovation process is divided into stages separated by gates. At each gate management or special committee makes a decision: whether or not to continue further process (Cooper, 1990). With the use this principle a lot of new ideas can be lost.

The logic of Closed Innovation created a sort of virtuous circle. It is shown in the Figure 9. Companies invest in internal R&D due to which they get breakthrough discoveries. These discoveries allow them to bring new products and features to market. Because of this, these companies make more sales, higher margins, which in turn allow them to reinvest more in further internal R&D, and that leads to new discoveries. And so the process goes in circles. (Chesbrough, 2003) The process described above corresponds to the traditional and presumptions about the innovation process.

Figure 9. The Virtuous Circle (Chesbrough, 2003, p.xxi)

For the most of the twentieth century this paradigm worked reliably enough. Within the boundaries of this paradigm, a huge number of new products and services were introduced, which opened horizons for future inventions and new markets.

(Chesbrough, 2003) Scientists stated that opening up technologies leads to weakening of IP protection and reduces the ability to capture the value for a developer and as a

consequence decrease willingness to invest in new developments (David and Greenstein, 1990).

In those industries with tough intellectual property protection, regulatory restrictions are high, start-ups appear seldom and the role of venture capital relatively small, the Paradigm of Closed Innovation is still working. However, in many other industries the logic of Closed Innovation paradigm has been entirely obsolete. This was facilitated by several factors. (Chesbrough, 2003)

The first factor which led to erosion of Closed Innovation paradigm is increased availability and mobility of skilled workers and specialists from different areas of knowledge worldwide. There are several causes of this factor. Among them is the growing number of graduates and postgraduate students. Another trend is the increased mobility of trained workers, thus is more widespread knowledge that they possess. Such mobility of well-trained staff allows even start-up firms to become pioneers in the commercialization of new promising inventions. (Chesbrough, 2003)

Another factor was the growing presence of private venture capital. After 1980, there was a sharp increase in the volume of venture capital. The large and growing pool of VC created a real danger for companies, staking on internal R&D. Individual professionals have become easier to lure in other companies and start-ups by offering them an attractive compensation package with an interesting balance of risk and reward. (Chesbrough, 2003)

The combination of the first two erosion factors led to the emergence of external options and ways to market for ideas sitting on the shelf. If an internal development organization of the company is not ready to take advantage of new research results, it can no longer count on the fact that the received idea will be on the shelf for a long time. Specialists who are able to obtain financing in the form of venture capital have other ways for commercialization of their ideas. (Chesbrough, 2003)

Due to the combined effect of the above factors, the capability of external suppliers has been dramatically increased. The large companies can be faster and realize greater potential of market opportunities. On the other hand, these external suppliers offer their services to all participants of the market, which increases the pressure on companies that have created large amounts of R&D projects currently sitting on the shelf. (Chesbrough, 2003)

These erosion factors in aggregate impacted an industry, the assumptions and logic, which at one time made Closed Innovation an effective approach, no longer work, at least to the extent conventional in the past. In implementing of fundamental technological breakthroughs, scientists and engineers are now aware of previously inaccessible external opportunities. If a company that financed these discoveries did not realize a breakthrough in time, scientists and engineers can use it independently in a new start-up firm. This start-up may commercialize this breakthrough. Very often, a company fails. But in case of success, such firm might achieve an initial public offering (IPO) or be acquired by another firm on profitable terms. Successful start-ups usually do not invest in the development of new fundamental technology breakthroughs. They try to find external technologies for external structures to pursue their commercialization instead. (Chesbrough, 2003) Figure 10 demonstrates the problem.

Figure 10. The Virtuous Circle Broken (Chesbrough, 2003, p.xxiii)

The emergence of this new, external path leads to breakage of the virtuous circle. The company, originally funded the breakthrough results, did not make a profit on its investment in research and development. Then the company that did profit from this breakthrough usually did not invest in the next-generation research.This interruption means that the next round of investment in basic research, fueling the subsequent advance will not take place. (Chesbrough, 2003)

In the economics of innovation there are some forces which compel the companies to change their approach to innovation process. These forces include rising costs of technology development, accompanied by reduction of the product lifecycle on a market. Moreover the probability of getting a good return on investment in innovation is decreasing. All these leads to the fact that maintaining the same level of R&D investments in the model of closed innovation is becoming increasingly difficult. (Chesbrough, 2006a)

Figure 11 illustrates changes in revenues and costs ratio in closed innovation model.

In this figure, ―closed model - before‖ shows that expected revenues are much higher than the development costs. However, as these costs are rising and as the market life of offerings is decreasing, the situation with net income more and more starts to resemble the ―closed model - after‖, that is, companies are becoming harder to recoup their innovation investment. (Chesbrough, 2006a)

Figure 11. The economic pressures on innovation (Chesbrough et al., 2006a, p.12)

All these factors have weakened the existing links between research and development in the Closed Innovation paradigm. (Chesbrough, 2003) Taking into account the given changes, it is necessary to change the approach to ways of getting knowledge and ideas and their subsequent realization. In situations where there are these erosion factors, Closed Innovation should be replaced by new approach, which is called Open Innovation (Chesbrough, 2003).